Chapter 11 • Gearing, the cost of capital and shareholders’ wealth
l Arising from the preceding point, managers fear that the market may view making
a share issue as a sign that the directors believe the shares to be overpriced in the
stock market. Alternatively, it could be viewed as an act of desperation, only to be
undertaken when the business has no option. These points are likely to make it
difficult to make an issue and may lead to a low issue price.As a result, according to the pecking order theory, businesses will tend to finance their
activities in the following sequence:
1 Retained profit.
2 Debt, which is relatively cheap to raise, particularly if it is in the form of a term loan
from a bank or similar institution.
3 Equity share issue.The pecking order theory is sometimes put forward as a strict alternative to the
trade-off theory, but there is the possibility that they could work together. For example,
businesses may broadly follow the principles of the trade-off theory but try to avoid
new share issues and, perhaps, rely on debt finance rather more than strictly dictated
by the trade-off theory.Evidence on the pecking order theory
Graham and Harvey (2001) undertook a major survey of attitudes of senior managers in
a large sample of larger US businesses in 1999. The range of the study was wide, but they
paid quite a lot of attention to testing the pecking order theory. Graham and Harvey
found that US managers’ behaviour seemed to be consistent with both theories. They
found that businesses are reluctant to issue new shares where it is perceived that exist-
ing shares are undervalued, and that this is an important consideration in share issue
decisions. They report that senior managers in more than two-thirds of businesses
believe that their shares are undervalued. Deloitte (2007) surveyed a number of senior
financial managers of major UK businesses in the autumn of 2007. The survey indicated
that 63 per cent of these managers believed that the stock market undervalues their
own business. This was despite the fact that 60 per cent of them believed that the market
fairly values businesses in general. This is consistent with the pecking order theory.
Graham and Harvey (2001) also found that most businesses had a target gearing
ratio, which is inconsistent with the pecking order theory.
Frank and Goyal (2003) tested the pecking order theory on the basis of what a broad
cross-section of US businesses actually did (rather than what managers said that they
felt) during the period 1980 to 1998. They found that the businesses behaved exactly
in line with the trade-off theory and not as they would have been predicted to behave
had the pecking order theory been valid.
Bunn and Young (2004) taking a similar approach to Frank and Goyal, but using
UK data, found clear support for the trade-off theory.
Mehrotra, Mikkelson and Partch (2005) analysed the behaviour of 98 US businesses
and concluded that they appeared to act in a manner that was consistent with the
trade-off theory, but not with the pecking order theory.
Barclay and Smith (2005) found that businesses seem to have target gearing ratios,
which is in line with the trade-off theory. They also noted that the US businesses that
they analysed seemed to be prepared to deviate from the target for periods of time,
appearing to be temporarily following the dictates of the pecking order theory.